Problem Identification
The memo aims to analyze the effects of switching from traditional costing to activity-based costing (ABC) on the selling prices of the goods and services offered by our organization. The company X, a manufacturing organization that creates various items, has been allocating overhead expenses to its products using the conventional costing method (Mahesha, 2022). Due to the variety of its production processes, there has been rising worry that the standard costing approach may not adequately reflect the full costs incurred by our products.
Description of Activity-Based Costing
A technique for cost allocation known as “activity-based costing” (ABC) allocates overhead costs to goods based on the particular activities that produce those costs. Instead of using a single cost driver based on volume, as in traditional costing, ABC employs multiple drivers to allocate costs more precisely (Quesado & Silva, 2021). By linking costs to specific activities, ABC provides users with a clearer understanding of cost drivers and their relationship to products, thereby enhancing their comprehension of product costs. This approach enhances decision-making by closely aligning costs with the activities that generate expenses, resulting in more effective resource utilization and pricing.
Influence of Activity-Based Costing on the Company
Due to the divergent cost allocation techniques, the move to Activity-Based Costing (ABC) may impact product selling prices. Traditional costing relies on a single cost driver, such as direct labor or machine hours, which can lead to errors when different goods have different manufacturing methods and require different resources (Mahesha, 2022). Conversely, ABC allocates costs in accordance with specific activities, providing a more realistic picture of cost drivers and their impact on goods. By minimizing cost distortions and aligning expenses with actual operations, ABC enables more informed price decisions, thereby improving the competitiveness and profitability of its products.
The method used by ABC to identify and allocate expenses to various operations improves understanding of the costs associated with each product. Since the expenses associated with each product’s activities are clearly defined, a greater understanding enables more precise pricing decisions (Quesado & Silva, 2021). Companies can make informed pricing decisions and enhance their competitiveness and profitability in the market by linking expenses to specific activities.
Calculation Example
Calculation
The key distinction between traditional and activity-based costing is overhead apportionment, or, in other words, how overheads should be distributed across each unit. Due to this, when one uses activity-based costing, rather than recovery rates, some activities can be identified separately (Mahesha, 2022). Corresponding to these activities, there will be some cost pools (the total cost incurred for that activity). Next, there will be some cost drivers (a specific aspect of an activity, for example, “delivery” is an activity; then “number of deliveries” will be a cost driver). Now the cost driver rate will be calculated, i.e., cost pool/cost driver.
Example
Below, the impact is illustrated with a realistic example.
Suppose there are three products, R, S, and T, and the total overheads are £310000. Let the base be person-hours of 2000, then with traditional costing,
Overhead Recovery Rate = Total Overheads/Base Selected = 310000/2000 = £155 per hour.
Labour hours for R=25, S=480, T=50.
Although this does not match 2000 hours, other products and activities were completed during the remaining hours.
References
Mahesha, V. (2022). A comparative study of activity based costing and traditional costing as a fragment of pricing. SAARJ Journal on Banking & Insurance Research, 11(2), 1-9. Web.
Quesado, P., & Silva, R. (2021). Activity-based costing (ABC) and its implication for open innovation. Journal of Open Innovation: Technology, Market, and Complexity, 7(1), 41. Web.